With new U.S. swaps definitions, the horse is finally put before the cart

NEW YORK, July 24 (Thomson Reuters Accelus) – The definition of swaps finalized by the U.S. futures regulator is the linchpin in an overhaul that will change the swaps market landscape markedly and offer the promise of lower risk.

In an effort to bring the over-the-counter (OTC) swaps into the regulatory fold for the first time since they appeared in 1981, the Commodity Futures Trading Commission (CFTC) issued a set of final rules this month defining a “swap” under the Dodd-Frank Act, section 721. These rules complement the agency’s other final rule on end-user exemptions as well as those adopted by the Securities and Exchange Commission on “security-based swaps” and “security-based swaps agreements.” They also delineate the jurisdiction for mixed swaps between the agencies.

The swap rules are intended to bring transparency to and lower overall risk for the markets to ultimately avoid a crisis-prone environment similar to the one in 2008, when taxpayers had to bail out AIG as the company’s $2 trillion worth derivatives portfolio almost brought down the financial system. This is all good news for the buy-side, composed mainly of large corporations that are swaps buyers. They will certainly welcome the protection, transparency and segregation of customer funds offered by the newly centralized format of the swap trades, even if they will be required to post more collateral.

The definition rules, long sought by frustrated industry participants, form the cornerstone for other rules on swaps that the CFTC had promulgated earlier, such as those on new internal and external business conduct standards, swap dealer and major swap participant registration requirements, and near-real time reporting of prices and swaps volumes. Swaps market participants were unable to implement or position for the other rules without knowing what constituted a swap or end-user exemptions.

The definitions will be helpful also in shaping future rules, such as the conduct standards between sell-side entities such as banks and the buy-side, internal standards for chief compliance officers, registration for swap data-repositories, gross margin requirements, and legal segregation for comingling of swaps due for November 2012.

In other words, with the definition of swaps completed, the regulators have finally put the horse in front of the cart. The rules stipulate that reporting requirements on the interest rate and volume of swaps will have to start 60 days after their official publication on the Federal Register.

Instruments defined as swaps

Broadly speaking, the rules define the following instruments as swaps: interest rate swaps, currency swaps, commodity swaps (including energy, metals and agriculture), broad-based index swaps (such as index credit default), as well as options. However, the definition excludes — to the dismay of CFTC Commissioner Bart Chilton– forwards and forwards with embedded options so long as they are based on nonfinancial commodities and are intended for delivery.

The regulators, notably, have been mindful of the distinction between the necessary hedging activity that a corporation has to undertake as an end-user to protect itself from a particular risk exposure, and the trading business of the swap dealer capitalizing on the differences on risk mismatches between standardized and customized products.

Certain banks that are big swap players have already incurred or will soon do incur heavy costs because of their swap dealer designations. The visible costs are related to revamping of operational systems, enhancement of risk management practices, and registration and documentation. The less visible costs are those stemming from loss of liquidity for relatively illiquid assets used in customized swaps. If such tailored swaps cannot be molded into the standardized format required by the regulators to be brought into the clearinghouses, the high margin required may drive them out of existence.

Given these costs, can or will the banks avoid being designated as swap dealers? Unlikely, for the following three reasons.

Anti-evasion provisions

Firstly, the anti-evasion provisions of the rule authorize the CFTC to define as “swap” any transaction the Commission deems as willfully structured to evade regulations of swaps. Any possible transformation of currency or interest rate swaps into a series of foreign exchange forwards or foreign exchange swaps with the intention to obtain exemption from the Treasury is, therefore, likely to get flagged.

Secondly, the banks will not find it easy to profit from a possible “regulatory arbitrage” by transferring their trading desks overseas, because the overhaul of the swaps market is, after all, a G-20 effort, and any such adverse undertaking is destined to be short-lived. Additionally, the rules’ stringent clauses on extraterritoriality severely nullify any advantage of such a move.

The de minimus rule (a non-netted notional threshold for swaps trade volume) applies not only to companies domiciled in the United States and to their affiliates overseas, or to branches of foreign companies operating on U.S. soil. It is an aggregate number that takes into account any trade that is entered in a U.S. parent company’s book even if the trade occurs between two non-U.S. entities. Therefore, trading desks, even if transferred elsewhere, would still likely end up being supervised by the U.S. regulators.

Lastly, the banks would not be able to devise a non-financial entity to which they would then transfer their swap dealings (in similar style to special purpose entities crafted for the purpose of off-balance sheet debt issuance). The rules disqualify such practice by clearly defining the end-user exemptions, which pertain to insurance products and arrangements that are to be used for commercial and consumer purposes only.

“Overall, given the ongoing Libor debacle, the (JPMorgan) losses, and the pressure mounting on the regulators, the avenues for banks to utilize any loopholes are shrinking,” said University of Maryland Law School professor Michael Greenberger, a former CFTC head of trading and markets.

Does that all mean bad news for the big swap players, namely JPMorgan Chase, Goldman Sachs, Bank of America, Citigroup and Morgan Stanley? Not necessarily.

Firstly, CFTC commissioners Jill Sommers and Scott O’Malia hinted at providing some relief on the onerous requirements for the swap dealers and major swap participants during the agency’s public meeting on July 10, 2012.

Secondly, swap dealers will no longer have to be bound by credit limits that their credit departments typically impose on each counterparty with which the swap dealers trade, since the counterparty exposure will now be borne by the clearinghouses. This will allow the swap dealers to effectuate more trades, as these trades would no longer be booked in the dealers’ books but rather with the clearinghouses.

Furthermore, registered swap dealers will have a leg up over their unregistered counterparts in trading with “special entities.” The swap dealer de minimis exception is limited to $25 million, rather than the current $8 billion for OTC trades with commercial end users. This small de minimis exception will discourage unregistered dealers from trading with “special entities,” says Andrea Kramer of McDermott, Will & Emery.

Experts are divided on how the rules will shape the swaps market. TABB Group analyst Will Rhode said he is “confused” by the rules. “The rules were intended to foster competition and unbundle the swaps market, however, the costs for the players on both sides will result in creating a massive negative impact for the swaps market.”

Holland West of Dechert offered a more upbeat assessment: “I believe that, despite the significant costs, there will actually be growth in the swaps markets because the clearinghouse model would provide dealing with creditworthy counterparties, and the higher margin requirements will provide protection which may be driven down by high level of competition.”

Whatever the resulting volume of activity, the new transparency and protection in the regulated swaps market will give participants a better chance of sleeping soundly at night, knowing they will not suffer if and when the next crisis hits.